CAPS Roundtable: Inflation, Deflation, and Your Portfolio

Is the U.S. economy headed for significant inflation or deflation? There's perhaps no more important question for the future value of your portfolio. We've asked two of the top investors from our Motley Fool CAPS community of more than 140,000 investors for their outlook on the economy, as well as to help us identify the best and worst opportunities in the market regardless of what lies ahead for the U.S. dollar. Here's what the CAPS community members had to say.

Are we looking at deflation or inflation over the next 12 months, and what are the leading indicators that we should focus on to answer this question?

UltraLong: My favorite indicator of inflation is probably the most widely followed: the M2 money supply. M2 money supply measures, among other things, the amount of currency in circulation. We've seen M2 increase at an average of 7.7% over the past few years, and, in 2008, we saw a massive capital injection that spiked the amount of currency in circulation.

I'm a firm believer in looking toward history to help guide us in the right direction, and chances are looking increasingly strong that we are headed toward a period of high inflation. Since 1960 we have seen M2 money supply spike over 10% growth five times, and in three of those periods inflation spiked up to double digits. The only time we did not see this occur was in 2001, when inflation failed to creep up higher than 5%. Although we have seen a strong divergence between M2 and inflation over the last two years, I think we need to consider just how those economic conditions affected the money supply. Prior recessions did not involve a credit crisis like we recently experienced. Couple that with historically low federal fund rates, and I think we have a recipe for significantly high inflation roughly 30-36 months down the road. As for the next 12 months, I think we will see a very dangerous lull before commodities roar higher.

Another indicator I follow (but place less significance on) is the Consumer Price Index (CPI). The CPI roughly measures the average pricing of baskets of goods over time and therefore is a decent indicator of whether or not inflation exists. The index has shown that we've already seen a 3% jump in the CPI since December 2008's figures, and that's with inflation currently running in the negative by 1.4%. This negative divergence would just be further proof that inflation will be marching higher very soon.

Intelledgement: Well, a bubble burst-engendered downturn in the business cycle should result in deflation, but the world's central banks averted that outcome by injecting massive amounts of liquidity into the system and by propping up zombie financial institutions right and left. So long as the printing presses keep working, a deflationary spiral is not in the cards -- and their capacity to keep money printing most likely exceeds 12 months.

The key underlying issue is the strength of the dollar (and that is our canary-in-a-coalmine leading indicator). Obviously the dollar is in a long-term secular decline because of unsustainable spending by the U.S. government as well as the concomitant policies of promoting overleveraging by both individuals and financial institutions. These trends were terrible under Bush and, despite some deleveraging, have on balance gotten worse under Obama. Thus, the incentive for the debtors to devalue the dollar grows stronger every day.

But predicting the short term is very difficult because there are powerful interests lined up behind delaying the inevitable. U.S. politicians don't want the dollar collapse to happen on their watch -- at least not suddenly -- because of the risk of social (and political) disruption. And foreign holders of U.S. dollars don't want to see the value of their U.S. dollar investments dissolve before they can redeploy into commodities, and that is by necessity a slow process (because trying to cash in too many dollars too quickly runs the risk of causing the crash immediately). China in particular has a strong additional interest in keeping the U.S. consumer -- and the dollar -- going until their own middle class is up to speed because they need sustained growth to absorb the continued supply of new job seekers and thereby minimize their own risk of potentially dangerous social/political unrest.

So, I believe it is also unlikely that serious inflation will happen within the next 12 months. The world's central banks are likely to be able and willing to lend enough support to the dollar to avoid a meltdown in the currency. And the U.S. economy is too weak to generate a serious uptick in demand. Ergo, minimal inflation.

This could eventually end badly ... possibly if support for the dollar is not cut off soon enough -- resulting in a loss of confidence in all fiat currency accompanied by material social/political unrest as well as a calamitous downturn in the business cycle caused by demand destruction for everything except food, medicine, tobacco, alcohol, ammunition, and razor blades. In this worst-case scenario, we could have runaway inflation for these consumer staples and massive deflation simultaneously. The probabilities are low, however, that this would occur over the next 12 months.

What is the play based on your outlook?

UltraLong: The initial play here should have been bullish, but it is getting very close to a stalemate. Moderate inflation historically has created bullish markets while inflation gone wild (anything over 6%) seemingly leads to a stagnant market. There will come a time when the increases we are seeing in commodity prices will become a detrimental drag on the economy, much like we saw when oil climbed over $90 a barrel back in 2008. My hands tied and forced to choose, I think we are looking at very stagnant growth approaching the latter half of this rolling 12-month period, and I'm inclined to bet we take a significant turn south in the market shortly after the holiday season.

Intelledgement: Under present circumstances, capital preservation is paramount. I am currently long commodities (precious metals and agriculture) and emerging markets (China, Brazil, India, and Malaysia) because they are best able to make hay while the sun shines. Similarly, I like high tech because it has outsized emerging-markets exposure. I am also short long-term U.S. Treasuries and am looking at shorting the dollar. I am prepared to sell the emerging markets and high-tech positions and go short the market when the macros deteriorate. Some favorites would be SPDR Gold Shares (NYSE: GLD) , iShares MSCI Brazil Index (NYSE: EWZ) , iShares Dow Jones U.S. Technology (NYSE: IYW) and ProShares UltraShort Lehman 20+Year Treasury (NYSE: TBT) .

Given the worst-case scenarios, I am also recommending that my clients plan to be prepared for a period of social unrest (supply of dry food, circulated silver coins, talk to neighbors to assess their level of preparedness, etc.). Make love, not war; be prepared for both.

What is the one stock or sector you are confident will outperform even if you are wrong about the direction of the general price level for goods and services?

UltraLong: Assuming inflation goes up or remains tame as it is now, I don't think you could go wrong investing in the oil-refining sector over the next 12 months and beyond. I've been quite vocal in a past blog about the cash cows that exist in the refining sector.

Historical trends have shown that during or slightly after recessionary periods, refining margins tend to shoot upward. In addition, you have the crack spread, which simply measures how profitable it is for a refiner to crack crude down into its sellable components, coming off their lowest levels in nearly two decades. History has shown that crack spreads don't stay in negative territory for long periods of time. Even if oil were to rise along with significant inflation, refiners would continue to turn a substantial profit. Some favorites in this sector would be Valero Energy (NYSE: VLO) , Sunoco (NYSE: SUN) and Holly (NYSE: HOC) . [You can learn more from UltraLong by visiting hismember pageon CAPS.]

Intelledgement: LOL! Define "wrong about the direction of the general price level for goods and services." If the collapse I expect never happens, then the emerging-markets investments are good for a generation. If it happens in the next 12 months, which I also don't expect, then I'll go with the razor blades and the ammo. [To learn more aboutIntelledgement's approach to investing, you can visit hisCAPS member pageor theinvestment advising servicehe manages.]

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Disclosure is important to us here at The Motley Fool.We selected CAPS Members UltraLong and Intelledgement to weigh in on these subjects because they are top-notch contributors to the Fool community. However, we have not verified whether or not they have any position in these stocks.We thought you'd like to know that. You can learn more about The Motley Fool's disclosure policyhere.

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He modifies the formula favored by Glen Rudebusch, of the San Francisco Fed:

Fed funds target = 2 + 1.5 x inflation - 2 x excess unemployment

Which would be:

2 + 1.5(1.6) - 2(5) = -5.6%

That is to say, the optimal Fed Fund Rate should be -5.6%. :) So, according to Krugman, we'll stay at near zero for a while....

And that's the pickle. Will high unemployment prevent inflation such that the Fed can keep rates low to stimulate the economy? Assuming the unemployment rate doesn't come down quick enough and inflation starts to accelerate, then outoffocus may be spot on with is stagflation forecast.

Actually, I'd suspect that Intellegement's scenario would play out in which we'd see serious inflation in commodities and a price collapse for most everything else.